Session 6 Slides

MANAGEMENT CONTROL
Session 6
Chapter 23
Relevant Costing for
Managerial Control
LEARNING OBJECTIVES
CONCEPTUAL
C1 Describe the importance of relevant costs for short-term
decisions.
ANALYTICAL
A1 Evaluate short-term managerial decisions using relevant
costs.
PROCEDURAL
P1 Determine product selling prices using cost data.
© McGraw-Hill Education. 23-2

LEARNING OBJECTIVE C1:
DESCRIBE THE IMPORTANCE OF
RELEVANT COSTS FOR SHORT-
TERM DECISIONS.

DECISION MAKING
Learning Objective C1: Describe the importance of relevant costs for short-term
decisions.
• Decision making involves five steps:

1. Define the decision task.
2. Identify alternative courses of action.
3. Collect relevant information on alternatives.
4. Select the preferred course of action.
5. Analyze and assess decisions made.
Exhibit 23.1
• Define Task and Goal
• Identify Alternative Actions
• Collect Relevant Information
• Select Course of Action
• Analyze and Assess Decision
RELEVANT COSTS AND BENEFITS
Learning Objective C1: Describe the importance of relevant costs for short-term decisions.
• Costs that are applicable to a particular decision.

• Costs that should have a bearing on which alternative a manager selects.
• Costs that are avoidable.
• Future costs that differ between alternatives.
• Three types of costs that are pertinent to the discussion of relevant costs
are:
• Sunk costs
• Out-of-pocket costs
• Opportunity costs

RELEVANT COSTS (1 OF 2)
• Sunk costs are the result of past decisions and cannot be

changed by any current or future decisions. Sunk costs are
irrelevant to current or future decisions.
• Out-of-pocket costs are future outlays
of cash associated with a particular decision. Out-of-
pocket costs are relevant to decisions.

RELEVANT COSTS (2 OF 2)
• Opportunity costs are the potential

benefits given up when one
alternative is selected over another.
Opportunity costs are relevant to
decisions.
• Management must also consider
relevant benefits.

NEED-TO-KNOW 23-1 (1 OF 2)
Learning Objective C1: Identify characteristics of corporations and their organization.
Match each of the terms below with its definition.

a. Additional costs incurred from a course of action
b. Incremental revenue from a course of action
c. A future outlay of cash
d. Potential benefit lost from taking a course of action
e. A cost that arises from a past decision and cannot be
changed

Learning Objective C1: Identify characteristics of corporations and their organization.
e. A cost that arises from a past decision and cannot

1. Sunk cost
be changed
2. Out-of-pocket cost c. A future outlay of cash
d. Potential benefit lost from taking a course of

3. Opportunity cost
action
4. Incremental cost a. Additional costs incurred from a course of action
5. Relevant benefit b. Incremental revenue from a course of action

LEARNING OBJECTIVE A1:
EVALUATE SHORT-TERM
MANAGERIAL DECISIONS USING
RELEVANT COSTS.

ADDITIONAL BUSINESS (1 OF 4)
Learning Objective A1: Evaluate short-term managerial decisions using relevant costs.
The decision to accept additional business should be based

on incremental costs and incremental revenues.
Incremental amounts are those that occur if the company
decides to accept the new business.
FasTrac currently sells 100,000 units of its product. They
are operating at 80% of full capacity. The company has per
unit and annual total sales and costs as shown in the
following contribution margin income statement.

Exhibit 23.2

A current buyer of FasTrac’s products wants to purchase

additional units of its product and export them to another
country. This buyer offers to buy 10,000 units of the product at
£8.50 per unit, or £1.50 less than the current price. The offer
price is low, but FasTrac is considering the proposal because
this sale would be several times larger than any single previous
sale and it would use idle capacity.
Should FasTrac accept the offer?

FasTrac should accept the offer.

Exhibit 23.3

A company receives a special order for 200 units that requires

stamping the buyer’s name on each unit, yielding an
additional fixed cost of £400 to its normal costs. Without the
order, the company is operating at 75% of capacity and
produces 7,500 units of product at the costs below. The
company's normal selling price is £22 per unit. The sales
price for the special order is £18 per unit.

Variable costs per

Costs (7,500 Units) Fixed costs
unit
Direct materials £37,500 £5.00
Direct labor 60,000 £8.00
Overhead (30%
20,000 £0.80 £14,000
variable)
Selling expenses (60%

25,000 £2.00 £10,000
variable)

The special order will not affect normal unit sales and will not
increase fixed overhead and selling expenses. Variable selling
expenses on the special order are reduced to one-half the normal
amount. Should the company accept the special order?
In order for the special order to be accepted, it must 1) increase
net income; the incremental revenue must exceed the
incremental expense, and 2) not adversely impact normal sales.

Yes, the company should accept the special order.

MAKE OR BUY (1 OF 4)
• Incremental costs are important in the decision to make a product or

purchase it from a supplier.
• The cost to produce an item must include:
1) direct materials
2) direct labor
3) incremental overhead
• We should not use the predetermined overhead application rate to
determine product cost in the decision.
FasTrac currently makes Part 417, assigning overhead at 100

percent of direct labor cost, with the following unit cost:
Cost to Make Part 417
Make
Direct materials £0.45
Direct labor 0.50
Factory overhead 0.50
Total cost to make £1.45
Normal, predetermined overhead application rate is 100% of direct labor

cost.
Learning Objective A1: Evaluate short-term managerial decisions using relevant
costs.
FasTrac can buy Part 417 from a supplier for £1.20. How
much overhead do we have to eliminate before we should
buy this part?
Assume management computes an incremental overhead
rate of £0.20 per unit if it makes the part. . .

Make versus Buy Analysis

Make Buy
Direct materials £0.45 ----
Direct labor 0.50 ----
Overhead costs ? ----
Purchase price ---- £1.20
£1.20
We must eliminate £0.25 per unit (£1.20 - £0.95) of overhead, to make the
total cost of making the component less than the purchase price of £1.20.

A company currently buys a key part for a product it

manufactures. The company buys the part for £5 per unit and
believes it can make the part for £1.50 per unit for direct materials
and £2.50 per unit for direct labor. The company allocates
overhead costs at the rate of 50% of direct labor. Incremental
overhead costs to make this part are £0.75 per unit. Should the
company make or buy the part?

(per unit) Make Buy

Direct materials £1.50
Direct labor 2.50
Overhead 0.75
Cost to buy the part ____ £5.00
Total cost per unit £4.75 £5.00
The company should make the part, because the £4.75 cost to
make is less than the £5.00 cost to buy.

SCRAP OR REWORK (1 OF 3)
costs.
• Often in manufacturing processes, we have products that do not pass

inspection. We can either sell them as is, or rework them to improve the
quality.
• As long as rework costs are recovered through sale of the product, and
rework
does not interfere with normal production, we should rework rather than
scrap.
• Costs incurred in manufacturing units of product that do not meet quality
standards are sunk costs and cannot be recovered so they are irrelevant.

costs.
Example: FasTrac has 10,000 defective units that cost £1.00

each to make. The units can be scrapped now for £0.40 each or
reworked at an additional cost of £0.80 per unit. If reworked,
the units can be sold for the normal selling price of £1.50 each.
Reworking the defective units will prevent the production of
10,000 new units that would also sell for £1.50.
Should FasTrac scrap or rework?

Exhibit 23.5
Scrap 10,000 units × £0.40 per unit
£ per unit Scrap Rework
Sale of scrapped/reworked units………………………………………………… £0.40 £1.50
Less out-of-pocket costs to rework defects……………………………….. (0.80)
Less opportunity cost of not making new units…………………………… _____ (0.50)
Incremental net income (per unit)………………………………………………. £0.40 £0.20
Decision: FasTrac should scrap the units now.

SELL OR PROCESS FURTHER (1 OF 3)
costs.
• Businesses are often faced with the decision to sell partially

completed products as is or to process them further for sale
as other products.
• As a general rule, we process further only if incremental
revenues exceed incremental costs.

costs.
Example: FasTrac has 40,000 units of partially finished product Q.

Processing costs to date are £30,000. The 40,000 unfinished units
can be sold as is, for £50,000 or they can be processed further to
produce finished products X, Y, and Z. Processing the units further
will cost an additional £80,000 and will yield total revenues of
£150,000.
FasTrac must decide whether the added revenues from selling
finished products X, Y, and Z , exceed the costs of finishing
them. . .
Process Further into

Sell as Product Q
Products X, Y, and Z
Incremental revenue £50,000 £150,000
Incremental cost ----0---- (80,000)
Incremental income £50,000 £70,000
Decision: FasTrac should process further; by doing so, it will earn

an additional £20,000 of income (£70,000 – £50,000).
The £30,000 of previously incurred manufacturing costs are
excluded from the analysis. These costs are sunk, and they are not
relevant to the decision!
1. £10,000 of manufacturing costs have been incurred to produce

Product Alpha. Alpha can be sold as is for £30,000 or processed
further into two separate products. The further processing will cost
£15,000, and the resulting products can be sold for total revenues of
£60,000.
Alpha Sell as is Process Further
Incremental cost 0 (15,000)
Alpha should be processed further; doing so will yield an extra £15,000 (£45,000 - £30,000) of
income.
2. £5,000 of manufacturing costs have been incurred to produce

Product Delta. Delta can be sold as is for £150,000 or processed
further into two separate products. The further processing will cost
£75,000, and The resulting products can be sold for total revenues of
£200,000.
Delta Sell as is Process Further
Incremental cost 0 (75,000)
Delta should be sold as is; doing so will yield an extra £25,000 (£150,000 - £125,000) of income.

SALES MIX SELECTION
• When a company sells a variety of products, some are likely to be

more profitable than others.
• Management concentrates sales efforts on more profitable products.
• If production facilities or other factors are limited, producing more
of one product usually means producing less of others.
• In this case, management must identify the most profitable
combination, or sales mix of products.
• Management focuses on the contribution margin per unit of
scarce resource.
SALES MIX SELECTION WITH LIMITED
RESOURCES (1 OF 2)
Example: FasTrac makes and sells two products, A and B using the same
machines. A and B have the following selling prices and variable costs per unit:
Product A Product B
Selling price £5.00 £7.50
Variable costs 3.50 5.50
However, it takes one hour to produce one unit of Product A, while it

takes two hours to produce one unit of Product B. We need to figure each
product’s contribution margin per machine hour.
SALES MIX SELECTION WITH LIMITED
RESOURCES (2 OF 2)
Product A Product B
Selling price per unit………………………………….. £5.00 £7.50
Variable costs per unit……………………………….. 3.50 5.50
Contribution margin per unit (a)………………. £1.50 £2.00
Machine hours per unit (b)………………………… 1.0 2.0
Contribution margin per unit…………… £1.50 £1.00
Decision: Even though Product A’s unit contribution is less, it has

a higher contribution margin per machine hour. FasTrac should
produce more Product A!
A company produces two products, Gamma and Omega. Gamma sells

for £10 per unit and Omega sells for £12.50 per unit. Variable costs are
£7 per unit of Gamma and £8 per unit of Omega. The company has a
capacity of 5,000 machine hours per month. Gamma uses 1 machine
hour per unit, and Omega uses 3 machine hours per unit.
1. Compute the contribution margin per machine hour for each product.
2. Assume demand for Gamma is limited to 3,800 units per month.
How many units of Gamma and Omega should the company
produce, and what will be the total contribution margin from this
sales mix?
(per unit) Gamma Omega

Sales £10.00 £12.50
Variable costs (7.00) (8.00)
Contribution margin per unit £3.00 £4.50
Machine hours per unit 1 3
Contribution margin per machine hour £3.00 £1.50
Total machine hours available 5,000

Machine hours used for production of Gamma (3,800 units x 1 MH per unit) 3,800
Machine hours available for production of Omega 1,200
Machine hours used for production of Omega (1,200 MHs / 3 MH per unit = 400 units) 1,200
Remaining machine hours 0

Contribution margin (calculated on a per unit basis)

Gamma 3,800 units × £3.00 contribution margin per unit £11,400
Omega 400 units × £4.50 contribution margin per unit 1,800
Total contribution margin £13,200
Contribution margin (calculated on a per machine hour basis)

Gamma 3,800 machine hours × £3.00 contribution margin per machine hour £11,400
Omega 1,200 machine hours × £1.50 contribution margin per machine hour 1,800
Total contribution margin £13,200

SEGMENT ELIMINATION (1 OF 4)
A segment is a candidate for elimination if its revenues are less

than its avoidable expenses.
Avoidable expenses are amounts the company
would not incur if it eliminated the segment.
FasTrac is considering eliminating its Treadmill Division
because it reported a £500 operating loss for the recent year…
Let’s take a closer look at the division’s expenses...

Exhibit 23.9
Avoidable Unavoidable
Treadmill Division Total
Expenses Expenses
Sales………………………………………………………………..... £47,800
Cost of goods sold………………………………………………. 30,000 £30,000
Gross
17,800
profit…………………………………………………………..
Direct expenses
Wages expense……………………………………………… 7,900 7,900
Depreciation expense—Equipment……………… 200 £200
Total direct expenses…………………………………… 8,100
Departmental contribution to overhead……………… £9,700

Avoidable Unavoidable
Treadmill Division Total
Expenses Expenses
Indirect expenses
Rent and utilities expense
3,150 3,150
…………………………….
Advertising expense……………………………………… 400 400
Insurance expense………………………………………. 400 300 100
Share of office department expenses…………… 3,060 2,200 860
Share of purchasing department expenses…. 3,190 1,000 2,190
Total indirect expenses………………………………… 10,200
Operating income (loss)…………………………………….. £(500)
Total avoidable expenses…………………………………… £41,800
Total unavoidable expenses………………………………… £6,500

Sales £ 7,800
Avoidable expenses 41,800
Decrease in income £ 6,000
Do not eliminate the Treadmill Division!

A bike maker is considering eliminating its tandem bike division

because it operates at a loss of £6,000 per year. Division sales for the
year total £40,000, and the company reports the costs for this division
as shown below. Should the tandem bike division be eliminated?
Keep Tandem Division Eliminate Tandem Division

Cost of goods sold £30,000
Direct expenses 8,000
Indirect expenses 2,500 £3,000
Service department costs 250 2,250
Total £40,750 £5,250

Avoidable Expenses Unavoidable Expenses

Sales £40,000 £0
Total costs and expenses 46,000 5,250
Net income (loss) (£6,000) (£5,250)
Quantitative Analysis: Total avoidable costs of £40,750 are greater than

the division’s sales of £40,000, suggesting the division should be
eliminated.
Other factors might be relevant, since the shortfall in sales (£750) is
low. For example, are sales expected to increase in the future? Does the
sale of tandem bikes help sales of other types of products?
EXHIBIT 23.10 KEEP OR REPLACE
EQUIPMENT
FasTrac currently makes Part 417, assigning overhead at 100

percent of direct labor cost, with the following unit cost:
Increase or (Decrease) in
Net Income
Cost to buy new machine £(100,000)
Cash received to trade in old machine 25,000
Reduction in variable manufacturing costs 72,000*
Total increase (decrease) in net income £(3,000)
*18,000 × 4 years
LEARNING OBJECTIVE P1:
DETERMINE PRODUCT SELLING
PRICE USING COST DATA.

TARGET COSTING
Learning Objective P1: Determine product selling price using cost data.
• Companies may use cost-plus pricing to determine selling

prices.
• Factors that determine price include:
• Consumer preferences
• Competition
Target costing = Expected selling price – Desired profit

OTHER PRICING METHODS
• Alternatives to cost-plus pricing are based on product or

variable costs.
• Companies must adjust their desired markup percentage
upward to ensure selling price covers all costs.
14% target return x assets of £1,000,000 = £140,000 target
profit
£140,000 / 10,000 units sold = £14 target profit per unit
Markup % = £14 / £70 = 20%

VARIABLE COST METHOD
• Cost-plus pricing method

• Factors that determine price include consumer preferences and
competition.
• Target costing = expected selling price – desired profit.

END OF PRESENTATION
© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No
reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education. 23-50

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MANAGEMENT CONTROL

© McGraw-Hill Education. 23-2

© McGraw-Hill Education. 23-3

• Decision making involves five steps:

• Costs that are applicable to a particular decision.

© McGraw-Hill Education. 23-5

• Sunk costs are the result of past decisions and cannot be

© McGraw-Hill Education. 23-6

• Opportunity costs are the potential

© McGraw-Hill Education. 23-7

Match each of the terms below with its definition.

© McGraw-Hill Education. 23-8

e. A cost that arises from a past decision and cannot

2. Out-of-pocket cost c. A future outlay of cash

d. Potential benefit lost from taking a course of

4. Incremental cost a. Additional costs incurred from a course of action

5. Relevant benefit b. Incremental revenue from a course of action

© McGraw-Hill Education. 23-9

© McGraw-Hill Education. 23-10

The decision to accept additional business should be based

© McGraw-Hill Education. 23-11

© McGraw-Hill Education. 23-12

A current buyer of FasTrac’s products wants to purchase

© McGraw-Hill Education. 23-13

FasTrac should accept the offer.

© McGraw-Hill Education. 23-14

A company receives a special order for 200 units that requires

© McGraw-Hill Education. 23-15

Variable costs per

Direct materials £37,500 £5.00

Direct labor 60,000 £8.00

Selling expenses (60%

© McGraw-Hill Education. 23-16

© McGraw-Hill Education. 23-17

Yes, the company should accept the special order.

© McGraw-Hill Education. 23-18

• Incremental costs are important in the decision to make a product or

FasTrac currently makes Part 417, assigning overhead at 100

Normal, predetermined overhead application rate is 100% of direct labor

© McGraw-Hill Education. 23-21

Make versus Buy Analysis

© McGraw-Hill Education. 23-22

A company currently buys a key part for a product it

© McGraw-Hill Education. 23-23

(per unit) Make Buy

© McGraw-Hill Education. 23-24

• Often in manufacturing processes, we have products that do not pass

© McGraw-Hill Education. 23-25

Example: FasTrac has 10,000 defective units that cost £1.00

© McGraw-Hill Education. 23-26

Sale of scrapped/reworked units………………………………………………… £0.40 £1.50

Less out-of-pocket costs to rework defects……………………………….. (0.80)

Less opportunity cost of not making new units…………………………… _____ (0.50)

Incremental net income (per unit)………………………………………………. £0.40 £0.20

Decision: FasTrac should scrap the units now.

© McGraw-Hill Education. 23-27

• Businesses are often faced with the decision to sell partially

© McGraw-Hill Education. 23-28

Example: FasTrac has 40,000 units of partially finished product Q.

Process Further into

Decision: FasTrac should process further; by doing so, it will earn

1. £10,000 of manufacturing costs have been incurred to produce

2. £5,000 of manufacturing costs have been incurred to produce

© McGraw-Hill Education. 23-32